What is Variable Interest Rate?
The Short Answer
Variable Interest Rate explained simply
A variable interest rate, also known as a floating or adjustable interest rate, is an interest rate on a loan that changes periodically. Unlike a fixed interest rate, which stays the same for the entire loan term, a variable rate is tied to a benchmark index. Common benchmarks include the prime rate, the London Interbank Offered Rate (LIBOR), or the Secured Overnight Financing Rate (SOFR). As this benchmark rate moves up or down, so does the interest rate on your loan, which directly impacts your monthly payment amount.
Real-World Example
The Small Business Loan Example
Imagine a small business takes out a loan with a variable interest rate tied to the prime rate plus 2%. If the prime rate is 5%, their initial interest rate is 7%. If the prime rate later drops to 4%, their interest rate would then become 6%, reducing their monthly payments. Conversely, if the prime rate rises to 6%, their interest rate would increase to 8%, making their payments higher.
Why this matters
Variable interest rates can offer lower initial payments compared to fixed rates, which can be attractive for businesses looking to minimize early costs. However, they also introduce risk. If interest rates rise significantly, your loan payments could become much higher, impacting your cash flow and profitability. Understanding this risk is crucial for financial planning and managing your business debt effectively.
When considering a variable interest rate loan, always look at the caps and floors. These set the maximum and minimum your rate can go, giving you some protection against extreme market swings.
When considering a variable interest rate loan, always look at the caps and floors. These set the maximum and minimum your rate can go, giving you some protection against extreme market swings.
Curious what your business is worth? Get a free estimate.
Understand your business value before making financing decisions.
